Managing risk is a critical part of any investing strategy. Of course, when it comes to buying and selling stocks, there’s no sure thing, but some investments carry more risk than others. Risk tolerance is about investors’ willingness to hold stocks through choppy waters. Simply put, what’s the worst that can happen to an investor’s portfolio before they panic and sell?
Risk tolerance is a qualitative measurement. Even two investors with the same on paper portfolio risk may have different degrees of risk tolerance. There are three basic levels here.
Investors with an aggressive risk tolerance will typically place maximum returns as their primary goal, and are willing to accept maximum risk in order to achieve that goal. In some cases, these investors are knowledgeable about the factors that influence market movement move. And they typically know how that movement will affect different asset classes.
Investors with a moderate risk tolerance are seeking a balance between aggressive growth and predictable income. They will accept some risk to their portfolio’s value, but balance is their guiding principle. People with a moderate risk tolerance will frequently have shorter time horizons (5 to 10 years) than aggressive investors.
Investors with a conservative risk tolerance have capital preservation as their primary goal. These investors are willing to miss out on potentially large returns to avoid big losses. Many investorswith conservative risk tolerance will look at dividend-paying defensive stocks in reliable sectors such as utilities. These stocks tend to have low volatility.
Here are some strategies for managing your risk tolerance.
- Regularly Evaluate Your Plan
- Diversify Your Investments
- Establish An Asset Allocation Plan
The important part is knowing yourself and your goals for your portfolio, so you can select the proper approach.
Regularly Evaluate Your Plan
With the advent of mobile trading apps such as Robinhood and Webull, it’s easier than ever for anyone to become a shareholder. However, the phrase “a fool and his money are soon parted” comes to mind. Many investors are simply buying stocks without having a strategy. And that is a plan doomed to fail.
Even experienced investors who start out with a plan can get off track. And before long, their portfolio is missing objectives. In some cases, a stock is no longer the growth stock it once was. In other cases, an investor’s goals and outlook have changed. Whatever the case, a key risk tolerance strategy is to regularly evaluate your plan.
For most investors, that starts with asking themselves honest questions about their investment goals, time horizon and savings. There are many excellent resources to help define your investment goals. In many cases, you will probably be asked questions like:
- What is your current age?
- At what age do you plan to retire?
These will be followed up with questions that may ask you to rank statements on a scale of Strongly Disagree to Strongly Agree. These statements would be similar to:
- Are you willing to accept an above-average risk to get above-average returns on your investments?
- Would you be tempted to sell your investments if they lose money over the course of a year?
- Do you feel anxious about investing in the stock market?
- Do you know a lot about investing and the economy?
The results you get are just a guideline. But tools like this force you to think about how comfortable you are with investing, and potentially losing, your money.
Diversify Your Investments
One of the most important ways to manage your risk tolerance is by diversifying your investments. The principle behind diversification is that different asset classes (stocks, bonds, cash, etc.) move in different directions at different times. In fact, you’re counting on it.
A diversified portfolio is like the food pyramid. Different foods provide different benefits to our bodies. However common sense suggests that consuming too much of one group at the expense of another may not allow you to meet your health and wellness goals.
It’s the same way with investing. Diversification is about making conscious, purposeful decisions to protect your financial health by dividing your investment dollars among a variety of asset classes. And diversification goes beyond just dividing your assets between stocks, bonds, and cash. Even within each investment type, diversification is important.
By putting your money in different asset classes your portfolio should always be protected no matter what a specific asset class is doing at a particular time.
Establish An Asset Allocation Plan
Frequently investors who are managing their risk tolerance set up an asset allocation plan. By creating an asset allocation plan, they designate a specific percentage of your portfolio for each asset class and maintain that mix.
For example, stocks and bonds usually move in opposite directions. This means when the stocks in a portfolio are up, a diversified portfolio may start to get overweighted to stocks. To correct this, following an asset allocation will require investors to take some profit from the stocks that are performing well and move that money into other assets. This requires discipline. And it also means investors have to avoid the fear of missing out (FOMO). But that discipline should provide the peace of mind from knowing that your portfolio is balanced for your risk tolerance.
One way to ensure your portfolio is balanced is by investing in mutual funds or exchange-traded funds (ETFs). By design, these funds spread the individual risk that is inherent in any security across a basket of stocks that are similar in attributes based on the funds objective.
On the date of publication Chris Markoch did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Chris Markoch is a freelance financial copywriter who has been covering the market for over six years. He has been writing for Investor Place since 2019.